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Africa’s growth tragedy is at least partially explained by financial under development (Easterly and Levine 1997). Africa remains today one of the most financially under-developed parts of the world. Financial under-development is frequently associated with a country’s inability to mobilise sufficient amounts of saving to satisfy the demand for credit. A recent study by the World Bank has, however, shown that African banking systems, although lacking in depth compared to other regions in the world, are excessively liquid (Honohan and Beck 2007). That is to say, savings mobilisation does not appear to represent a binding constraint on African banks’ ability to lend. Instead, African banks complain of a lack of credit worthy borrowers while at the same time households and firms complain about lack of credit. The same study shows that the least developed banking systems in Africa are also the most liquid, which implies that resolving the paradox of excess liquidity may hold the key to understanding African financial under-development. To do so requires focussing on the structure and mechanics of African credit markets.

The main contribution of this paper is to put forward a plausible explanation of African financial under-development in the form of a bad credit market equilibrium the ‘African credit trap’. We show that the root of the problem could be either moral hazard—taking the form of strategic loan defaults—or adverse selection emanating from the lack of good projects. Theoretically, the two are almost indistinguishable but we make an attempt to gauge empirically which of the two is the most likely cause.